New research reveals sustainable, responsible, impact-focused portfolios can outperform traditionalinvesting
By R. Paul Herman and Srdana Pokrajac
More than $220 trillion is invested globally across all types of assets – stocks, bonds, real estate and more. When selecting how to invest this money for a portfolio, we can attempt to follow, the Nobel-prize winning theories taught in MBA programs, and reinforced by the media, that the capital markets are “efficient.” In other words, all the information needed for investors to make sound, attractive decisions is widely available and is swiftly incorporated in the prices of those assets.
However, are the theories actually true? Or is real life investing not optimal?
One example of this not-seemingly-rational market behavior that has left many “traditional investors” in awe is perhaps the high valuation of companies such as Twitter or Facebook when they go public.
A common question is “Where is the value of Twitter or Facebook captured on the financial statements?” to which we could add: “Is this valuation based on past or future performance?”
The above questions could be asked about just any company whose shares are traded on the stock market. In fact, across the S&P500, 80 percent of the S&P 500 stock market valuation is driven by factors that are not accurately captured on the financial statements (Ocean Tomo’s analysis calls them “intangibles”) – and are typically ignored or under-analyzed by investors, analysts, advisors and fund managers.
According to interviews with institutional investors representing trillions of investor capital, the tools from Morningstar, FactSet, and other firms “primarily analyze historical risk and return, not the full set of factors that drive future risk and return.”
Yet forward-thinking analysts and investment managers are looking ahead through the windshield, not just back- ward in the rear-view mirror. “Past performance does not indicate future results” is embedded in every financial offering. We hear that, but when making decisions, many people focus on what’s already happened instead of what future results and risks those companies may encounter.
Modern Portfolio Theory (MPT), distilled in 1952 by Nobel-prize-winning Dr. Harry Markowitz at the University of Chicago, is seen as the gold standard of portfolio construction. To apply MPT systematically, investors typically use index funds that follow the market. However, the underlying assumptions are that the market prices are efficient and accurate, incorporating all relevant information.
Nearly a decade of research, analysis from our sustainable, responsible, impact investing industry, and more than 20 academic papers, reveal the new fundamentals of investing. At HIP Investor, with cross-disciplinary analysts, we have identified more than 20 quantifiable factors creating cash flow and profit, or lessening risk, that are not used by Wall Street experts. Most financial analysis looks backward at what has already transpired to predict the future and make forecasts. But what are the forward-looking sources and drivers of shareholder value creation? Is it time to re-examine our investing practices and financial fundamentals?
There are many factors that are included in the stock price that are not so accurate and measurable after all, so why rely on this type of in- formation, especially since we like to think of ourselves as “rational human beings?”
Also, no common standard is used by Wall Street investors for measuring net beneficial impact on society, which could significantly improve the performance of in- vestments in all asset classes worldwide.
Investors can enhance return potential and lower risk by investing in equities of companies and bonds of companies, governments and nonprofits that incorporate the following in their strategy, operations, and management:
Valuing People as an Asset: A portfolio model of publicly listed firms in Fortune’s Best Companies to Work For, calculated by Wharton finance professor Alex Edmans, typically outperforms the S&P500 (since 1998).
Natural Resource Efficiency: The S&P Carbon-Efficient Index of firms more efficiently using energy has out- performed the S&P500 since its inception in 2011.
Leadership Inclusive of All Talent: Boards of firms with one or more women on the Board have realized higher return on equity with lower volatility (2005-2011), according to Credit Suisse.
In a comparison of portfolios that invest in mutual funds and ETFs that include sustainable firms with portfolios adhering to traditional MPT approach sustainable, high-impact portfolios with 24 (HIP 24) and 10 funds (HIP 10) incurred lower risk and stronger returns relative to risk over 1, 3, 5, and 10 year periods. Across all time periods analyzed, the HIP 10 portfolio approach shows less risk and exceeds the annualized returns of the Nobel-Prize winning MPT approach. New fundamentals can transform traditional investing.
Sustainable portfolios can outperform the market, as they integrate meaningful, quantifiable information that is knowable yet ignored by most investors, analysts, endowments, pensions, and foundations.
Smart investor portfolios diversify to mitigate the potential downside of future risks and seek the upside associated with all the possible opportunities. More than $220 trillion of global financial as- sets could be stronger and more resilient by measuring its future risk exposure and al- locating to funds and investments that can lower that risk, seek enhanced returns, and spur net positive impact for society. To date, US-SIF identifies $3.7 trillion in the USA and $4 trillion in Europe that is currently pursuing positive impact in portfolios.
Every investment—stock, bond, or fund—can be rated for its future risk, financial return potential, and net impact on society. In the three years ending 12/31/2013, a diversified allocation of HIP-focused funds exceeded the MPT portfolio funds; more sustainable-friendly funds performed above the financial “efficient frontier” and color-coded “green” for lower future risk and more positive impact. Using investment ratings of this type to measure the true impacts of investing—and then divesting less sustainable and rein- vesting in more sustainable—can strengthen your portfolio.
Every investment and fund has a future risk-return-impact profile; Muni bonds can rate higher on impact by funding nonprofits in healthcare and education, as well as government services for water and cities. Private-equity funds (and firms like KKR which partner with Environmental Defense Fund, edf.org) can manage risks and pursue impacts more systematically than publicly listed companies. Hedge funds can be low transparency about their exposure to future risks.
Do you know the future risks embedded in your portfolio? Is it built for 21st century opportunities? Portfolios designed thoughtfully that incorporate knowable-yet-ignored factors of value-creation and future-risk reduction can realize stronger performance, more resiliency and a better society.
R. Paul Herman is CEO of HIP Investor Ratings LLC, which serves investors, advisers, fund managers and retirement plans. Srdana Pokrajac is an advisor to HIP. See all disclosures at www.HIPinvestor.com.